On September 23, 1998, the boardroom of the New York Fed was a tense place. Around the table sat the heads of every major Wall Street bank, the chairman of the New York Stock Exchange, and representatives from numerous European banks, each of whom had been summoned by the Fed to discuss the highly unusual prospect of rescuing what had, until then, been the envy of them all, the extraordinarily successful bond-trading firm of Long-Term Capital Management. Roger Lowenstein's When Genius Failed is the gripping story behind the Fed's unprecedented move, the incredible heights reached by LTCM, and its eventual dramatic demise.

Lowenstein, a financial journalist and author of Buffet: The Making of an American Capitalist, uncovers and examines the personalities, academic expertise, professional relationships, and layers of numbers behind LTCM's roller-coaster ride with the precision and knowledge of a skilled surgeon. The fund's enigmatic founder, John Meriwether, spent almost 20 years at Salomon Brothers, where he formed its renowned Arbitrage Group by hiring academia's top financial economists. Though Meriwether left Salomon under a cloud of the SEC's wrath, he leapt into his next venture with ease, and enticed most of his former Salomon hires--and eventually even David Mullins, the former vice-chairman of the US Federal Reserve--to join him in starting a hedge fund that would beat all hedge funds.

LTCM began trading in February 1994, after completing a road show that, despite the Ph.D.-touting partners' lack of social skills and their disdainful condescension of potential investors who couldn't rise to their intellectual level, netted a whopping 1.25 billion dollars. The fund would seek to earn a tiny spread on thousands of trades, "as if it were vacuuming nickels that others couldn't see," in the words of one of its Nobel laureate partners, Myron Scholes. And nickels it found. In its first two years, LTCM earned 1.6 billion dollars, profits that exceeded forty percent even after the partners' hefty cuts. By the spring of 1996 it was holding $140 billion in assets. But the end was soon in sight, and Lowenstein's detailed account of each successively worse month of 1998, culminating in a disastrous August and the partners' subsequent panicked moves, is riveting.

The arbitrageur's world is a complicated one, and it might have served Lowenstein well to slow down at the start and explain in greater detail the complex terms of the more exotic species of investment flora that cram the book's pages. However, much of the intrigue of the Long-Term story lies in its dizzying pace (not to mention the dizzying amounts of money won and lost in the fund's short lifespan), and Lowenstein's smooth, conversational, but equally urgent tone carries it along well. The book is a compelling read for those who've always wondered what lay behind the Fed's controversial involvement with the LTCM hedge-fund debacle. --S. Ketchum

How One Small Bank Created a Trillion-Dollar Hole When Genius Failed is the extraordinary final instalment in a financial saga that began with the gambling on the futures markets in the 1980s. It is the conclusion of the poker players so memorably depicted in Liar's Poker and, fictionally, in Bonfire of the Vanities. By 1994 John Meriweather, the pivotal figure on the trading floor at Salomon Brothers during the 1980s when the firm had made $500 million annual profits in arbitrage alone, was out of work. To fill his time, he created a financial institution as much a product of the era of the 1990s as the futures floors had been in the 1980s: a hedge fund, named Long-Term Capital Management. Meriweather took to LTCM the brightest of his disciples from Salomon and added Nobel prize-winning economics from Harvard. The team believed that it could outsmart the markets in a strategy of hedge betting, leveraged to levels previously unseen. Even a small percentage profit could be turned into a huge financial gain if the stake placed was big enough. So LTCM bet big, very big. Hedge funds are the equivalent of private clubs on Pall Mall or exclusive Oxbridge colleges: you have to be invited to join. And you have to be extremely rich. LTCM's partners quickly included every bank on Wall Street and many of Europe's premier banks as well. They built up a fund of $100 billion. Which meant that they could really put some money down. And they made spectacular profits for a while. Until the pressure to keep achieving led to increasingly risky speculations and less protected gambles. When the markets in Brazil, Indonesia and Russia all crashed within months of each other it was as if a wrecking ball had ploughed through LTCM. But because they had continued to leverage their investments at very high multiples the effect was shared throughout the world's banks. When LTCM went down it threatened to open up a trillion-dollar black hole, a financial abyss that could have busted a continent and an entire banking system. In a classic tale of greed, ambition, pride and overbearing confidence in their ability to beat the market, Meriweather's poker players play out their last hand. A parable of extraordinary drama, it is also a brilliant morality story of our times and a vivid warning of capitalism's ability to consume its own.

This title tells the story of long-term capital management where a group of elite investors believe they can beat the market and, like alchemists, create limitless wealth for themselves and their partners. In fact, they create a trillion-dollar hole in the international banking system.

Roger Lowenstein has reported for the Wall Street Journalfor more than a decade and is a frequent contributor to the New York Times and The New Republic. He is the author of Buffet: the Making of an American Capitalist.

INTRODUCTION

William J. McDonough, the beefy president of the New York Fed, talks to bankers and traders often. McDonough wants to be kept abreast of the gossip that traders share with one another. He especially wants to hear about anything that might upset markets or, in the extreme, the financial system. But McDonough tries to stay in the background. The Fed has always been a controversial regulator - a servant of the people that is elbow to elbow with Wall Street, a cloistered agency amid the democratic chaos of markets. For McDonough to intervene, even in a small way, would take a crisis, perhaps a war. And in the first days of the autumn of 1998, McDonough did intervene - and not in a small way.

The source of the trouble seemed so small, so laughably remote, as to be insignificant. But isn't it always that way? A load of tea is dumped into a harbor, an archduke is shot, and suddenly a tinderbox is lit, a crisis erupts, and the world is different. In this case, the shot was Long-Term Capital Management, a private investment partnership with its headquarters in Greenwich, Connecticut, a posh suburb some forty miles from Wall Street. LTCM managed money for only one hundred investors; it employed not quite two hundred people, and surely not one American in a hundred had ever heard of it. Indeed, five years earlier, LTCM had not even existed.

But on the Wednesday afternoon of September 23, 1998, Long-Term did not seem small. On account of a crisis at LTCM, McDonough had summoned - "invited," in the Fed's restrained idiom - the heads of every major Wall Street bank. For the first time, the chiefs of Bankers Trust, Bear Stearns, Chase Manhattan, Goldman Sachs, J.JP. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley Dean Witter, and Salomon Smith Barney gathered under the oil portraits in the Fed's tenth-floor boardroom - not to bail out a Latin American nation but to consider a rescue of one of their own. The chairman of the New York Stock Exchange joined them, as did representatives from major European banks. Unaccustomed to hosting such a large gathering, the Fed did not have enough leather-backed chairs to go around, so the chief executives had to squeeze into folding metal seats.

Although McDonough was a public official, the meeting was secret. As far as the public knew, America was in the salad days of one of history's great bull markets, although recently, as in many previous autumns, it had seen some backsliding. Since mid-August, when Russia had defaulted on its ruble debt, the global bond markets in particular had been highly unsettled. But that wasn't why McDonough had called the bankers. Long-Term, a bond-trading firm, was on the brink of failing. The fund was run by John W. Meriwether, formerly a well-known trader at Salomon Brothers. Meriwether, a congenial though cautious midwesterner, had been popular among the bankers. It was because of him, mainly, that the bankers had agreed to give financing to Long-Term - and had agreed on highly generous terms. But Meriwether was only the public face of Long-Term. The heart of the fund was a group of brainy, Ph.D.-certified arbitrageurs. Many of them had been professors. Two had won the Nobel Prize. All of them were very smart. And they knew they were very smart.

This one obscure arbitrage fund had amassed an amazing $100 billion in assets, virtually all of it borrowed - borrowed, that is, from the bankers at McDonough's table. As monstrous as this indebtedness was, it was by no means the worst of Long-TermUs problems. The fund had entered into thousands of derivative contracts, which had endlessly intertwined it with every bank on Wall Street. These contracts, essentially side bets on market prices, covered an astronomical sum - more than $1 trillion worth of exposure.

If Long-Term defaulted, all of the banks in the room would be left holding one side of a contract for which the other side no longer existed. In other words, they would be exposed to tremendous - and untenable - risks. Undoubtedly, there would be a frenzy as every bank rushed to escape its now one-sided obligations and tried to sell its collateral from Long-Term.

Panics are as old as markets, but derivatives were relatively new. Regulators had worried about the potential risks of these inventive new securities, which linked the country's financial institutions in a complex chain of reciprocal obligations. Officials had wondered what would happen if one big link in the chain should fail. McDonough feared that the markets would stop working; that trading would cease; that the system itself would come crashing down.

James Cayne, the cigar-chomping chief executive of Bear Stearns, had been vowing that he would stop clearing Long-Term's trades - which would put it out of business - if the fund's available cash fell below $500 million. At the start of the year, that would have seemed remote, for Long-Term's capital had been $4.7 billion. But during the past five weeks, or since Russia's default, Long-Term had suffered numbing losses - day after day after day. Its capital was down to the minimum. Cayne didn't think it would survive another day.

The fund had already asked Warren Buffett for money. It had gone to George Soros. It had gone to Merrill Lynch. One by one, it had asked every bank it could think of. Now it had no place left to go. That was why, like a godfather summoning rival and potentially warring families, McDonough had invited the bankers. If each one moved to unload bonds individually, the result could be a worldwide panic. If they acted in concert, perhaps a catastrophe could be avoided. Although McDonough didn't say so, he wanted the banks to invest $4 billion and rescue the fund. He wanted them to do it right then - tomorrow would be too late.

2007-12-14 The writing on the wall

I am not an expert in finance; neither do I want to look into the details of LTCM's trading strategies. I was therefore still at a loss about what the LTCM's intricate financial schemes was all about even when I finished reading this book. Nevertheless, Lowenstein's work has impressed me very much since I read his another book 'Buffett: The Making of An American Capitalist' a few months ago. 'When Genius Failed' didn't disappoint me as well.

History repeats itself. Somewhat different as the backdrop and story of those events might have been, numerous financial debacles have taken place so far. Writers of financial history seem to find no shortage of materials on financial disasters. Sooner or later other similar books on the story of money games will appear in bookshops.